This year’s Nobel Prize in economics, awarded to Robert Hall of Stanford University and Michael Woodford of Columbia University, illuminated a seemingly whimsical connection: ice cream. The Royal Swedish Academy of Sciences honored them “for microeconomic foundations of macroeconomic stabilization,” a concept that a prize committee member, Timo Boppart of Stockholm University, vividly illustrated with an image of an ice cream menu during the announcement.
The Sweet Lesson of Sticky Prices
Boppart’s ice cream menu served as a poignant example to explain how firms set prices. He noted that “Prices do not adjust [on] a continuous basis. Firms instead set the price of this ice cream for a whole season.” This observation underpins the economic concept of “sticky prices,” which describes how prices can stubbornly remain fixed even as broader economic conditions shift. This seemingly minor detail, as the Nobel committee’s recognition underscores, carries profound implications for the entire economy.
Sticky prices are a foundational element of “New Keynesian economics,” a framework that has significantly reshaped macroeconomic theory and influenced how policymakers approach fighting recessions and managing inflation. The work of Hall, Woodford, and their peers has been instrumental in revitalizing the intellectual legacy of economics giant John Maynard Keynes, whose ideas faced significant challenges for a period.
Keynes’ Legacy and the 1970s “Brain Freeze”
John Maynard Keynes, often regarded as the father of macroeconomics, introduced revolutionary ideas during the Great Depression with his seminal work, The General Theory of Employment, Interest, and Money. He argued that economies could become trapped in prolonged slumps, and the free market, contrary to prevailing orthodoxy, would not always self-correct. Keynes advocated for the “visible hand” of government intervention to boost spending, create employment, and restore economic health, challenging the notion of the “invisible hand” alone guiding the economy to its full potential.
Keynesian principles guided economic policy for decades, with even Milton Friedman, a staunch free-market advocate, famously stating in 1965, “We are all Keynesians now.” However, the 1970s presented a formidable challenge. The economy experienced “stagflation”—a painful combination of high inflation and high unemployment—which existing Keynesian models struggled to explain. John Hassler, chair of the Nobel committee, noted that “For a long time, the recipes of Keynes seemed to work, but they then failed during the oil crisis in the 1970s when high unemployment and high inflation took over simultaneously.”
This period led some economists, including Nobel laureates Robert Lucas and Edward Prescott, to question Keynesian economics wholesale. Their critique centered on the reliance of Keynesian models on historical data patterns without adequately accounting for the forward-looking decisions of individuals and businesses—a call for “microfoundations.” Alternative theories, such as Prescott’s “real business cycle” theory, posited completely flexible prices and wages, leaving little room for involuntary unemployment during downturns.
Rebuilding Macroeconomics: A Fresh Scoop
It was into this intellectual debate that Hall and Woodford stepped. As Gregory Mankiw, an economist at Harvard University and a contemporary of Woodford, recalled, “Lucas and Prescott were ascendant, but a lot of us were skeptical of their conclusions… The sense was that the people who were rejecting the Keynesian model were throwing out the baby with the bathwater. And so rather than throwing it out, they wanted to sort of fix the problems.”
Hall and Woodford contributed significantly to rebuilding macroeconomics by integrating the decisions of individual people and businesses. Hall’s work advanced understanding of how expectations about the future influence current spending. Woodford built upon this, developing a comprehensive framework that combined these forward-looking spending decisions with the crucial element of sticky prices.
Returning to the ice cream example, if a recession causes demand to plummet, shops might not immediately lower prices. The costs of updating menus and signs, or uncertainty about the permanence of the demand drop, could lead them to keep prices “frozen.” Consequently, they sell fewer scoops, potentially leading to reduced worker hours or layoffs. This dynamic extends to wages, which Mankiw clarifies are also considered “sticky” by economists: “Most people don’t get their wages adjusted every month.” Across the economy, this price rigidity means that when spending falls, prices and wages do not adjust quickly enough to maintain buying and hiring levels, leading to declines in production and employment and explaining why people can remain unemployed for extended periods during recessions.
The Visible Hand’s Return
The integration of price rigidities into macroeconomic models was a critical breakthrough. As Boppart stated at the Nobel announcement, “Bringing in those price rigidities into the framework was absolutely key because this is the reason why the invisible hand cannot do its magic and there is room for policy intervention.” This insight affirmed that even when individuals and businesses act rationally and anticipate future conditions, sticky prices can still trap the economy in a slump, thus validating Keynes’ central argument for government and central bank intervention.
This “Keynes’ comeback” through New Keynesian economics successfully addressed the criticisms of older models by incorporating microfoundations while preserving the core insight that markets don’t always self-correct. Gregory Mankiw notes, “One thing that clearly differentiates Keynesian models from Real Business Cycle models was the flexibility or stickiness of prices. Most economists today — not all — but I think most economists today buy into the sticky price assumption.” These New Keynesian models have become indispensable tools for governments and central banks in formulating strategies to combat recessions and control inflation. Woodford’s theoretical contributions, for instance, were foundational to the development of “forward guidance,” a policy tool utilized by the Federal Reserve during the Great Recession under then-chair Ben Bernanke to provide economic stimulus when interest rates were already near zero.
